Conflicts & Problems faced by the Credit Rating Agencies

There have been many assertions that the rating agencies are very slow to change their ratings. However, at the same time, many governments claim that rating agencies are too quick to downgrade. Moreover, if the marketplace relies on the ratings, then rating changes themselves can cause further changes in the issuers financial situation. Downgrades can lead to increases in the cost of capital making borrowing more expensive. This could cause further deterioration in a county‘s or company‘s financial condition. (Note that this is not an issue in structured finance.) The impact of a downgrade is one of the biggest conundrums of the credit rating. This is known as the problem of pro-cyclicality. On the one hand, it is important for a CRA to issue correct credit ratings. On the other hand, the issuance of the credit rating can make the situation worse (Manso 2011).

Since the regulators do not set any standards for the ratings criteria, they view ratings from different rating agencies as equally valid, and therefore, substitutable. The problem with this is that this incorrect view is often adopted by investors. Another problem is that the output of the CRAs, namely their ratings will like not be comparable. This problem is a central to the issues of whether a credit rating is just an opinion, or something more. If any NRSRO can make up its own criteria, then how can they ever be wrong?

This can lead to issuer "rating shopping". This occurs when the issuer chooses the rating agency that has the weakest criteria to achieve a desired rating. As discussed in the analysis section, there have been several regulatory initiatives to try to limit rating shopping. These efforts, have thus far, failed. Even worse the rating shopping, is "rating catering". This occurs when the rating agency weakens its criteria in order to be hired to rate an issuer's debt (Rating Shopping or Catering?... 2012).

As discussed below, in section 2.4 many claim that the issuer-pay model is the most important conflict faced by CRAs and is the primary cause of inflated credit ratings and the

cause of the sub-prime crisis. It is obvious that a conflict exists when an organization is issuing an analysis that is paid for by the company that it is analyzing. The question is can this conflict be managed and regulated. This set-up is not unique to CRAs. Auditing firms are in exactly the same position. And, stock analysts are in a similar position.

Some claim that the investor-pay model limits conflict of interest, by removing the potential for pressure from issuers for higher ratings. But, the critics of this model maintain that it has its own conflicts. They claim that investors who own bonds and are subscribers, might pressure rating agencies not to downgrade a bond. Or, perhaps, if they are purchasing bonds, they might want a lower rating, in order to buy the bond at a lower price. These conflicts and the proposed regulatory and potential solutions are discussed later in this report.

In our modern capital markets, bonds are sold and traded all over the world. Different countries have their own regulations. While it may not be a theoretical problem, CRAs are under tremendous pressure to satisfy regulators around the world. Sometimes regulators can define things differently and cause a problem for CRAs.

Changes to criteria often take a long time. This can create a tremendous conflict for a CRA.

The CRA can only rate using existing published criteria, yet there could be a time period when it knows that criteria will likely change and lead to downgrades. If it rates a bond according to its current criteria that bond could be immediately downgraded upon the change in criteria. Understandably, this angers investors and regulators.

Some researchers (Freytag, A., Zenker, M. 2012), maintain that the source of the problems with the CRAs can be explained by the principal-agent problem. The problem with this view is that the relationships between the users of the ratings and the CRAs is more complex than a straightforward principal-agent model. The CRA has a relationship with issuers, regulators, and investors.

1) The Issuer-CRA relationship

The relationship between the issuer and CRA is the most obvious. Issuers hire NRSROs to rate their new bonds.

―An example of how the principal-agent problem occurs between ratings agencies and the company's (the principal) that hire them to set a credit rating. Because a low rating will increase the cost of borrowing for the company, it has an incentive to structure its compensation of the rating agency so that the agency gives a higher rating than what may be deserved. The rating agency is less likely to be objective because it fears losing future business by being too strict‖ (Principal-Agent Problem).

Although they are not part of the selling group as the investment bankers are, the CRAs act as an agent for the issuer, by enabling the issuer to sell its bonds to the market place. And, so in this context its duty is to the issuer who hires them. As a result, the CRA is less concerned about the surveillance of outstanding ratings or even the performance of their ratings. Their primary concern is on the initial rating. Their concern about the rating performance is limited to the effect on its reputation with issuers.

2) The Regulator-CRA relationship

As we have already noted, it is actually the regulators that are empowering the CRAs via the NRSRO designation. This regulatory license, as described by Partnoy, forces the issuers to use the CRAs. So, in asset classes like corporate bonds, where there are many issuers, CRAs are not as fearful of losing business. As a result instead of lowering criteria to get business, they simply can afford to save resources and not do an adequate credit analysis, as was the case with Enron. In this relationship, the CRA is acting on behalf of the regulators.

The regulators are supposed to control the risk of the institutions that they supervise.

Instead they delegate this to the CRAs. The regulators, however, do not pay for this service, nor do they control the product. The only way they can incentivize their agent, is by granting this license, and by controlling the rating process through regulation. Their incentive scheme is one of penalizing the CRAs for lack of compliance. But, if poor

performing ratings is not a violation, then there is no way in the current structure for the principal to control its agent. Moreover, in the current structure, the regulator does not choose or hire a particular CRA.

3) The Investor-CRA relationship

This relationship is the most complex. The investor is the user of ratings. The investor may use it in their investment analysis, or may simply use it to satisfy regulatory requirements.

The investor doesn‘t pay for the ratings nor does it get to choose the CRA. Yet, the CRA is performing a function for the investor. So, in this sense, the CRA is an agent for the investor. There is very little that the investor can do to get the CRA to provide good ratings.

All the investor can do is to decline to purchase bonds rated by a CRA that they want to avoid. If it is a large investor, or many investors that do not like the hired CRA, the issuer may then be motivated to hire a different CRA. But, because, thus far, the CRAs have not faced liability for poor analysis, the investor has had no way to control this agent. This lack of power for investors is what leads some to advocate for an investor-pay CRA framework.

Alternatively, the new regulations have tried to increase the potential for liability. But, as is demonstrated in the empirical section of this thesis, thus far, even with the new regulations, the CRAs have not been held accountable.

The investor-CRA relationship is made more complicated by the fact that not all investors want correct credit ratings. Some, as discussed, may want inflated ratings to show high risk adjusted-returns, while others may want correct ratings to be used in their investment process. So, effectively, there is not one principal in the case of the investor-CRA relationship.

The result of having different principals involved with the CRA-agent, the motivations for the CRA to act in a consistent manner are often conflicting. It appears from the financial crisis that the CRAs focused on their agent role with the issuers.

Some are of the view that CRA analysts are similar to equity analysts at the Wall Street firms. Indeed, there are some similarities. For example, they both use financial statements

to analyze the condition of a company. Moreover, they both may have motivations to make issuers happy by giving good reports. And, their information may be used by investors in their investment process. But, a key difference is that, whereas equity analysts make recommendations, such as buy or sell, CRA analysts do not make any such recommendations. A major problem and difference is that securities analysts have real liability for baseless recommendations or biased recommendations. In there was a major regulatory actions against them and a subsequent settlement with the SEC. Major penalties were imposed, and changes in the way research was structured and managed had to be changed at the investment banks (Ten of Nation‘s Top… 2003).

In some ways there might be more similarity between external auditors and CRAs. Both are giving opinions, not recommendations, based on a review of information provided by the issuer.

However, in the case of the accounting firm, they are just opining on whether or not the financial statements fairly reflect the company information and whether recognized standards for reporting were used. The approach has to be the same by all certified accounting firms as there are international standards for accounting. On the other hand CRAs, are giving opinions about future performance. There are no common standards, nor is there an agreement as to what the ratings mean.

In both cases, equity analysts and auditing firms, the principal-agent relationship exists, even though it is complicated as well by the fact that investors are the users of the output.